Can Netflix Outsmart Dexter?

It's been a busy 24 hours for Netflix (Nasdaq: NFLX  ) .

  • The stock closed nicely higher yesterday on a Credit Suisse analyst upgrade.
  • Jim Cramer talked up the shares last night, arguing that the stock could double after the Facebook IPO adjusts the market valuations of growing dot-com darlings.
  • There was another Netflix.com outage, disrupting streaming services and DVD queue management.

However, the one nugget that has a lot of cynics gushing is news that CBS' (NYSE: CBS  ) Showtime is about to pull the early seasons of Dexter and Californication from Netflix's catalog of more than 20,000 digital titles.

The move makes sense for Showtime on the surface. It's getting ready to roll out Showtime Anytime, a streaming service for active premium subscribers similar to what Time Warner's (NYSE: TWX  ) HBO is doing with HBOGo. The value of streaming Showtime shows as a cable channel subscriber diminishes if it's legally available cheaply elsewhere, so it wants to be the exclusive hub for its hit shows. In news originally broken by Crain's New York, CBS will be pulling the shows once its current deal with Netflix expires this summer.

Nurse Jackie jilt
There are three fatal flaws in Showtime's thinking.

The first flub is that Showtime wasn't airing current seasons of its shows on Netflix. It's largely the earlier seasons that are no longer lucrative. You're not seeing a lot of retail sales traction on the second season of Dexter after all of these years. Showtime is leaving incremental money on the table outside of the syndication opportunities that may be diluted with easily accessible streams.

The second flaw is that having these early episodes freely available to Netflix's 20 million paying subscribers has been a promotional winner. What does a Netflix customer do after streaming the first two seasons of Dexter? Those that get hooked likely check out the subsequent seasons before considering a subscription to Showtime to stay current. It's a gateway drug. No offense, Weeds.

The third oversight in Showtime's strategy is that Netflix still has the discs. Unlike any other streaming service, Netflix -- and an iffy Blockbuster -- are the only two companies with the regional distribution centers to offer fresh DVD rentals on top of video. Coinstar's (Nasdaq: CSTR  ) Redbox is limited by kiosk space and Amazon.com's (Nasdaq: AMZN  ) new Prime streaming smorgasbord will never grow physical distribution in these taxing times. If Showtime is making it a point to be the exclusive streaming provider of its vault, it will only help Netflix stand out more as the only financially feasible source for home-delivered Dexter seasons on disc.

Oh, and if that final point proves to be too burdensome for Netflix subscribers, that's still bad news for Showtime. Netflix's more than 20 million homes of couch potatoes will just stream other shows that are available.

Teaching old media some new media tricks
I'm going to make a prediction that is bolder than it may initially sound: By the end of next year, HBOGo and Showtime Anytime will be offered as standalone services.

It has to happen if either service stands a chance of succeeding. Right now, they are only available to existing subscribers of HBO and Showtime, respectively. This means that folks that are already paying a good chunk of change for basic cable or satellite television are the only ones that can pay even more for a premium movie channel package. This isn't working. Cord cutting continues, threatening to derail HBOGo and Showtime Anytime if the premium channel providers believe that this will be magical elixir to grow its subscriber ranks.

There will be resistance, naturally. Standalone streaming will make it less necessary to have cable service. Time Warner has CNN, Turner, TNT, Cartoon Network, and truTV to protect. It also spun off cable provider Time Warner Cable (NYSE: TWC  ) . CBS was split from Viacom (NYSE: VIA  ) , but its sister company watches over MTV, BET, Nickelodeon, Comedy Central, VH1, and Spike. In short, they will suffer if standalone streaming accelerates the cord-cutting process. However, there will also be greater pain ahead if HBOGo and Showtime Anytime let Netflix continue to run away with the mass market. They can't compete under the old media mold.

Showtime's killing a serial killer serial, but who is it ultimately killing?

Is Showtime right or wrong here? Share your thoughts in the comment box at the bottom of this queue.

Netflix and Amazon.com are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He is part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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  • Report this Comment On March 23, 2011, at 7:23 PM, David369 wrote:

    Good insight. I agree with the majority. Sometimes greed overcomes common sense and planning.

  • Report this Comment On March 23, 2011, at 11:04 PM, MKArch wrote:

    http://seekingalpha.com/article/252310-the-netflix-churn-cha...

    I've got an even bolder prediction Aristotle. If NFLX is still around in five years they will no longer offer a subscription based streaming service. There are two fatal flaws to NFLX subscription model. First it should be abundantly clear from the churn stats in the link above when NFLX hits the wall with new subscribers (which is not far away) they will quickly lose totals subs and have less money to spend on content which will lead to a death spiral. BTW the article mentions 120M households but there are only ~70M households with broadband. So far NFLX has signed up 50M subs although some could be repeats.

    The second fatal flaw is the fact that they compete with the cable companies for content and NFLX contributions to the content providers revenues is a pittance compared to cables contributions. Add up all the recent deal plus the estimate for a STARZ renewal and they spend ~$1B/ year for content. Comcast alone spends ~$7.4B/ year. I think Comcast charges ~$15.00/ month for STARZ. Their programming costs come in at ~38% of video revenues. Assuming ~38% of the $15.00/ month is what Comcast pays to STARZ that works out to ~$6.00/ month. That would wreck NFLX. The solution will be exactly what NFLX CEO mentioned a few months ago. If NFLX wants cheap content they'll just get less of it.

    I don't know where this idea that NFLX has any bargaining power with the content providers comes from but it should be clear by HBO's refusal to even deal with them, Showtime pulling programming and STARZ CEO prepping them to get the bottom of the barrel of their content library when they renew that NFLX is a paper tiger as far as the content companies are concerned. They'll let them have what ever their bread and butter cable customers don't care that NFLX gets (most of which cable also offers for free). That's exactly why Showtime is pulling content. To satisify their cable customers.

    I've heard two arguments from NFLX fans about why the service is so great that really make sense. First is getting STARZ content for a fraction of what it cost on cable. The second is they are adding content all the time and their library is only going to keep getting better. What happens when the library gets worse? Take at look at the churn stats in the article above again. That's before they start losing content. You say but NFLX has 20M and counting subs? 20M freeloaders is what the content providers see and they are putting an end to it. This is going to get ugly for NFLX. BTW churn is also the reason why they are getting into original programming. They need something to keep subs coming back year after year. Is one show going to do it? I don't think so. Comcast pays ~$7.4B for programming for almost the same number of subs NFLX has vs. ~$1B at NFLX. NFLX can't afford to pay what it cost to have enough content to keep subs coming back over the long haul, their subscription model is not sustainable. It's probably the reason most of the other streaming services out there are offering their product ala carte.

  • Report this Comment On March 23, 2011, at 11:29 PM, MKArch wrote:

    BTW I should also point out that Hastings sees this coming as well. That's why he won't put out churn stats after 2011 and is talking up expansion outside the U.S. so much. He knows this only lasts as long as they are continuing to add subs at high rates and that the U.S. is nearing saturation. I'm sure this is also why he won't allow analyst to ask questions directly on their cc's. he doesn't want some pesky analyst with a conscience pointing out the fact that this model looks to be in trouble when new sub additions slows down.

    It's unbelievable that no one is calling him on the carpet for this. I did see one explanation that makes sense though. NFLX all but tells you in their 10K that there is a secondary coming at some point. Given their insane market cap and share price it's about the smartest thing they could do right now. I've seen speculation that G.S. and others are falling all over themselves to upgrade and praise NFLX to get a piece of that secondary for their investment banking.

  • Report this Comment On March 24, 2011, at 10:29 AM, verylargelarry wrote:

    MKArch...

    One more position I'd like you to explain. Are you short NFLX????

  • Report this Comment On March 24, 2011, at 11:06 AM, MKArch wrote:

    VLL,

    I can't stay solvent as long as the market can stay irrational so the answer to your question is no. I don't short stocks except in CAPS.

  • Report this Comment On March 24, 2011, at 12:58 PM, David369 wrote:

    MKArch

    Good numbers/data but I think it's like comparing apples to oranges. What cable provides sort of overlaps NFLX or vice versa but.. I do like your pointing out there will come a point where new subscriptions slow to basically nil but I wonder how that panned out with cable. Shouldn't they be saturated now in most markets? Or is sat TV stealing from cable? I don't know but they have been around a heck of a lot longer than NFLX, nobody really uses antenna anymore. I see NFLX as another animal that content providers will sell to just like they sell to everyone else. Price, timing of release, etc will factor of course. I expect NFLX will "max out" one day but they keep pulling rabbits out of their hats to expand/change their business model. Remember when it was a "blockbuster by mail". Now look. Whats the next trick? Ok, Europe, China maybe. Deal with sat company for VOD for old movies? I don't know but I bought at $17.90 when people said they wouldn't last. As long as they do the magic I'll watch their show. BTW, never have subscribed to NFLX, never intend to.

  • Report this Comment On March 24, 2011, at 2:55 PM, bartoncreek1 wrote:

    So what is better for Showtime? Selling each season on Amazon video on demand, which is on every platform NFLX is on for $15 or say .99 cents an episode. Or licensing it to NFLX for .01 cents per subscriber as currently? It only takes 20,000 people to buy from Amazon to gain more revenue VS NFLX 20 million. As NFLX gets bigger it only gets worse.

    I can see the first seasons of old series being on NFLX but any subsequent seasons OR as Showtime is doing ongoing series on Amazon to much revenue there.

    Thus NFLX going it's own in the content arena

  • Report this Comment On March 24, 2011, at 3:37 PM, MKArch wrote:

    David369,

    Take a look at the article I linked in particular the chart detailing the numbers of subs walking away from NFLX. It's huge and it's recurring and the only reason it's not being discussed is because the even more massive number of new subs that are signing up are masking the number walking. Once NFLX saturates and new sub additions slow down they aren't going to hold steady they are going to rapidly lose total subscribers as new subs will no longer be offsetting older subs walking. That's going to force NFLX to spend less on content which will cause subs to walk faster in a death spiral.

    Comcast spend about 7X what NFLX does for content for about the same total number of subs right now in order to basically hold the line. They may lose small numbers to FioS or Satellite but they are not losing any to cord cutting as subs still want to the latest episodes of their favorite sitcoms, their local sports teams, their local news and all the other current programming they won't get with a NFLX subscription replacing cable, FioS or satellite.

    Cord cutting is a myth. The only chance NFLX subscription model has is to offer enough to entice subs to pay for their service on top of cable or FioS or Satellite. So far they've managed this on a bone headed deal STARZ made a couple of year ago that allowed NFLX subs to get STARZ premium content for a fraction of what the cable companies charge for the same content. That's about to end and with it NFLX primary appeal to subs. They are already walking in droves before Starz renews the contract and forces NFLX to pay orders of magnitude more money for what ever content the cable companies don't mind that NFLX gets (read bottom of Starz content barrel).

  • Report this Comment On March 24, 2011, at 7:01 PM, MKArch wrote:

    http://online.wsj.com/article/SB1000142405274870442580457622...

    Starz isn't even waiting until they renegotiate the contract. IMHO NFLX bulls that have convinced themselves that NFLX is sort of industry titan that force the content providers to deal with them on favorable terms are deluding themselves. It's the complete opposite, they are a piker trying to bluff their way into becoming a big time player. They pulled one over on Starz a couple of years ago but the industry is on to them now.

  • Report this Comment On March 24, 2011, at 7:44 PM, David369 wrote:

    MKArch

    Yeah looks like the numbers are there. You figure the saturation point has to hit eventually. I would assume mgmt at NFLX knows it better than anyone because they have the data to withhold. I can see that NFLX would have to pay less for content to stay in the black. I just wonder if content providers were told by NFLX that "we can't pay $10 per viewer but we will pay $5 per viewer per show, take it or leave it" and that the content providers will think about what percentage of the 20 million will watch (say 10 percent for ease) times $5 which would be $10 million. I know that's small change but if they can still sell the show to others (or use it for themselves) first and do the wait 90 day routine again then that small change might pay off. I figure NFLX will always be at the core a Blockbuster store via mail & wire. I think NFLX will do "tricks" to hold and/or increase subscriber base by buying some content (rarely) to entice new subscribers. The loss would hopefully be make up in volume.

    I figure one day NFLX will paint themselves into a corner. But I have to give them credit. For the life of me I never would have guessed they would have come so far so fast. Of course, that might be a problem. Sort of like a pyramid scheme that runs out of people, they almost have to keep expanding in either number of subscribers and/or value offered (so they can charge more). Only so many tricks you can do with one rabbit. Good insight MKArch.

  • Report this Comment On March 24, 2011, at 8:24 PM, MKArch wrote:

    David,

    To put the content problem in context as I've pointed out Cable, FioS and Satellite dwarf NFLX in contributions to Content providers revenues. So imagine Comcast who alone pays ~7X what NFLX pays for content negotiating with content providers and making it clear what ever deal they cut with NFLX Comcast will expect a better deal.

    So if you're a content provider do you slash prices that Comcast pays or force NFLX to pay more or accept less content in line with what they can pay relative to what Comcast is paying/ demanding? Of course you throw NFLX under the bus to make Comcast happy.

    In addition to this NFLX is already losing tons of subs on a constant basis that's being masked right now by even greater numbers of new subs taking their place. When they saturate and high growth in new subs ends their total sub count will quickly go backwards as existing subs continue to walk. That will force them to cut back on content to keep that cost in line with their diminishing sub count resulting in a death spiral for their subscription based streaming service. Getting squeezed by content providers trying to make their bread and butter cable customers happy will only hasten the collapse of NFLX subscription model.

  • Report this Comment On March 25, 2011, at 8:11 AM, David369 wrote:

    MKArch

    I can see where someone like Comcast would not be happy paying more than NFLX. I think you might be correct that NFLX is at (or so dang near it doesn't matter) the saturation point. It seems like a revolving door with subs roughly. NFLX has to do something to stay alive or to keep growing. I doubt if NFLX will ever have the quality (all things relative) content they have now in terms of new & "fresher" stuff along with the old. I would expect that by the end of this year we can tell if they are able to hold their position or not. I really don't expect to see their numbers going up...unless they pull a really big rabbit out of the hat or pull some numbers trick that makes things look better that they are. Actually I can't see why they are at their current value. I'm not complaining but I expect a gradual leveling off followed by a decline to realism at some point.

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